Chicago Real Estate Investors

Alright we have found an owner that is motivated and is willing to give you a lease on a property with the option to purchase it in four years.  The owner gets his mortgage paid and because he still owns the property the mortgage is not due on sale because no sale has taken place. Before we can get someone in the property so we are not stuck paying the lease we wanted to establish our pricing.

Here is one of the simplest ways to determine the pricing on rent-to-own properties.

The house you are selling is valued at $200,00 to $210,000. The market rent for a four-bedroom house like this one is $1,500 per month. The area has been appreciating at between 3-5% for the past two years.

The seller has agreed with a four-year lease option that requires a monthly rent of $1,400 and an option price of $190,000.

Determine your tenant buyer's sale price-

Let's take this information and price the property. The goal is to find a price for a tenant buyer that is below the possible future value of the property, but high enough above the buying price, so that a healthy profit can be made. In the example the house is to sell on a two-year lease option.

First, you take the current value of the property. Properties are valued by how much other comparable houses have sold for, so it is impossible to put an exact dollar amount on any given house. Since you are providing great financing, always start the current value of the property at the highest justifiable comparable property. In our example that means the current value is $240,000.

Projected value after two years-

Now calculate what the house would be worth at the end of the two years at it's current rate. Since the area has been appreciating from 3-5% we should take the higher number. In this case use 5% rate of appreciation. You must be realistic on rate of appreciation. Talking to different people may give you wildly different rates. Say you are informed that the rate for the area is 4%, 4%, 5%, 5%, 12%, commonsense should tell you that the 12% is not accurate. To calculate the projected future value of the house, multiply the current value by 1._rate of appreciation as a decimal. Multiply the $240,000 house by 1.05 to give you a one-year value of $252,000. Because we are selling the house on a two-year lease option, we will need a two-year value. Take the one-year value and again multiplying it by 1._ rate. Take $252,000 and multiply it by 1.05 to come up with a two-year value of $264,600. Next choose a price that is below this two-year projected value, but above the option price of $190,000, and still a great deal for the tenant buyer. Say you decide to set the price at $254,600 for this house. You can be more aggressive on the pricing but don't destroy the deal by asking to much.

Bump up the monthly rent with "rent credits"-

Now decide how much rent to charge the tenant buyer. First start by charging the market rent. Say the market rent is $1,500, so why not start at $1,495 (which many people think is a deal compared to the higher $1,500). We can then use "rent credits" to bump up the amount of rent you collect. A credit is applied to the  purchase of the property. So if the tenant buyer pays you $1,625 a month in rent, you could credit him with $125 per month off the purchase price. This way you are helping the tenant buyer get a great deal and increasing your cash flow. 

Collect a non-refundable option payment-

As for the option money to charge the tenant buyer, Typically collect from 3-5% of the value of the property as a non-refundable option payment from the tenant buyer. So an option payment between $10,000- $15,000. The best way to see if you have priced it right is to have real buyers come through the house. If people are not saying yes they want the property, there is something wrong with your pricing or the house needs does not show well.

REMEMBER-- Most buyers are NOT buying price, they are buying monthly payments they can afford and an up front payment they can handle.

Talk the buyer through the numbers Go slow and let them be faster with the math. Make sure that you maintain the good feelings you have worked so hard to create earlier in this process. If you have a calculator handy, let them work the numbers while you assisting telling them which buttons to push.

Now lets talk about the flip side of doing lease options-

Lease options are great, except when the sellers decides not to live up to their end of the bargain. You could force them to sell you the property, but this can cost thousands of dollars in legal fees and may take years to accomplish. To be in a better position,  the investment needs to be protected. Below are three ways to protect your option:

1. Record the option. If your option was signed before a notary, you can record your option in the public real estate records. This will give the world public notice of your interest. If the option was not notarized, you can sign an affidavit called a "memorandum of option" and file it in the real estate records where the property sits. Keep in mind that this does not create a lien, it only creates a "cloud" on the title.

2. Escrow the deed. If your seller has died or disappeared, you will have a big problem getting him to sign a deed. An escrow should be created up front in which a title company or attorney holds an executed deed. When you are ready to exercise, you simply tender the money to the escrow agent and collect the deed.

3. Record a mortgage. Typically a mortgage is recorded to secure payments on a promissory note. A mortgage can be recorded to secure performance of any agreement, even a purchase option. The optionee (buyer) will now be a lien holder, like a secured lender. If the seller refuses to sell the property, you foreclose. Now the SELLER has to go to court.

Avoiding the "equitable mortgage"-

Tenant/buyers who default on lease options do not always go away quietly. Sometimes, they fight the eviction and go into court kicking and screaming, "I HAVE AN EQUITABLE INTEREST IN THE PROPERTY." They are arguing that the lease/option is not a landlord/tenant relationship, but a seller/buyer relationship.  This has happened in Chicago. If the Judge agrees, your lease/option is "re-characterized" as an installment land contract. This may require you to foreclose the tenant, not just evict him. But also in some cases Judges have ruled that the rent credits must be returned to the tenant buyer. Some tips to protect your interest and avoiding the equitable mortgage:

1. Use separate agreements. Give the tenant a lease and a separate option agreement. Make sure the lease does not refer to the option. Many tenants lose their paperwork. Don't show any option agreement to the court until asked.

2. Keep your term short. Do not give tenants more than one year lease/options. Say the tenant wants one for three years, give a one year with two rights to renew. Draw up brand new leases and option agreements each time they renew.

3. Take a security deposit. Sellers don't take security deposits, landlords do. Even a small amount will show this as a landlord/tenant relationship.

4. Pay the taxes and insurance. Do not let the tenant pay the taxes and insurance.

5. Don't give large rent credits. The more "equity" the tenant has, the more likely a judge will favor an equitable mortgage.

6. Watch your language. Refrain from using the words "credit," "seller," and "buyer" in your agreements. Instead, use the words "non-refundable option," "landlord," and "tenant."

Sell your option for capital gains treatment-

If you lease option, this sub-lease option is a "sandwich." When the subtenant is ready to buy, there will be a simultaneous "buy and flip." The profit is taxed as ordinary income. If you held the option more than a year, you may qualify for capital gains treatment. Instead of selling the property, sell your option and let your subtenant exercise it directly from the owner.

Disclaimer: The foregoing is not intended to be given as legal, financial or tax advice, but intended for instructional use only. If you require legal, financial or tax advice you should seek the assistance of a qualified professional.